The COVID-19 pandemic brought renewed attention to the appropriateness of the SCR standard formula. This is an excellent time to apply the magnifying glass to how the standard formulae for the various risks were calibrated.
In this series, we will investigate selected SCR sub-modules including the history behind the calibration, the risks that were excluded from the calibration, and potential shortcomings as a result. PART I covers mortality risk. Look out for future articles in this series on other sub-modules.
The current Prudential Authority (PA) Financial Soundness for Insurers (FSI) solvency capital requirement (SCR) formula for mortality risk does not allow for mortality fluctuation risk and variation of the stress by the number of lives assured. Potential diversification benefits on larger volumes of business, or lack of diversification benefits on smaller volumes of business, are therefore not taken account of when the mortality stress (15% increase in the long-term mortality assumptions) is applied. It should also be kept in mind that the 15% was adopted from the UK Solvency II calibration and not calibrated to the South African market specifically.
Background - calibration:
The calibration of the mortality risk sub-module SCR for SAM (Solvency Assessment and Management) was adopted from the Solvency II calibration.
The initial Solvency II calibration for mortality risk was specified as a 20% permanent increase in mortality rates applied to each age. After a study published by Watson Wyatt in 2004 about 99.5% confidence level sensitivities, the general opinion of UK insurers was that the 20% shock was too high. The Solvency II stress calibration was consequently decreased to 10%.
However, after more studies by UK firms using internal models, the 10% shock was shown to be on the low side. Sampling results from 21 internal models, a median stress of 22% was noted, with an inter-quartile range of 13% to 29%. As such, CEIOPS1 increased the Solvency II shock to 15%.
This 15% made its way into our current Financial Soundness for Insurers (FSI) standards. South African data lacked the necessary completeness and reliability (compared to European data) to motivate deviating from the 15% used in Solvency II.
Unpacking the potential shortcomings:
From the background section above, there is a risk that the calibration might not be suitable for South African insured lives and/or population mortality experience if this is significantly different to European insured lives. Specifically, individual insurers should consider how suitable the calibration is for their specific target market. If internal capital models are available, these could be used to test the 15% assumption on in the context of the 99.5% confidence level specified by SAM. Mortality risk is usually a significant part of the life insurer’s overall SCR, therefore consideration and testing of the appropriateness of the prescribed mortality shock is worthwhile.
Another important consideration in assessing the appropriateness of the standard formula, is that the current mortality risk SCR sub-module does not allow for fluctuation risk and the number of lives assured does not affect the size of the capital requirement held.
Before SAM implementation, under the previous Standard for Actuarial Practice (SAP) 1042 CAR (Capital Adequacy Requirement), the IOCAR (Intermediate Ordinary Capital Adequacy Requirement) specifically allowed for mortality fluctuation risk, and for it to be inversely proportional to the number of lives assured. 3
Not explicitly allowing for fluctuation risk and the dependency on the number of lives assured, are unlikely to have noticeable impacts for insurers with large books of business. For large businesses, the parameter risk (calibration of the 15%) is typically more important than fluctuation risk. This is because as the number of lives assured increase, the variability around the mortality best estimate assumptions reduces.
However, since mortality fluctuation risk is not allowed for explicitly under SAM (as it is in the previous SAP104 mortality CAR formula), it is possible that the mortality risk component of the SCR may be understated for smaller insurers. This was further substantiated by a data study in the SA QIS2 exercise4.
As noted in SAP104 (2017, version 9), reinsurance could be used as a tool to mitigate fluctuation risk. The consideration of fluctuation risk is therefore especially relevant for smaller insurers without substantial reinsurance arrangements in place.
In evaluating the appropriateness of the mortality risk standard formula, insurers should be aware that the current standard formula does not allow for mortality fluctuation risk. This is particularly relevant for smaller insurers where fluctuation is typically more significant than for larger insurers. The SCR may therefore be understated for smaller insurers, especially those without reinsurance agreements in place.
Reference & further reading: This article uses information from the SAM steering committee Position Paper 66 – Life SCR - Mortality Risk (fsca.co.za)
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1 Committee of European Insurance and Occupational Pensions Supervisors.
2 The previous SAP104 version 9 of August 2017 can be accessed here: SAP104 v9 (actuarialsociety.org.za).
3 Mortality fluctuation risk allowed for in IOCAR
4 The exercise’s results report can be accessed here: SAM_SA_QIS2_Report.pdf (fsca.co.za).